THE WORLD'S DEBT PROBLEM is that too many people are getting something for nothing. Unearned income in the form of interest paid on bank deposits produces nothing but leads to an increase in the money supply, exponential debt growth and inflation.

THE SOLUTION is to remove deposit interest from the financial system. To do this, public interest-free money will have to replace private interest-bearing bank debt. Otherwise there is no practical way to control the amount of money in circulation. Normal banking operations and bank profits will not be affected by the change because, while the money supply will grow more slowly with the needs of the productive economy, inflation will be maintained close to zero and the financial system will be practically risk-free.

The interest banks pay on their domestic deposits will be removed from existing loans when public interest-free money is introduced. That will leave the banks unable to pay interest on their existing foreign debt, so the agency in charge of the public money supply will fund the banks' foreign interest costs until that debt is repaid. Unless more of a debtor country's productive assets are sold to foreigners, the banks' foreign debt can only be repaid when its current account is positive. A tax-neutral Foreign Transactions Surcharge will be used to raise the cost of foreign transactions in debtor countries so their current accounts become positive enough to repay the banks' foreign debt over time.

DEBT

After-tax interest paid on deposits is unearned income in the hands of deposit holders because it is not supported by any market production. It represents a domestic debt, Ms, owed by the productive sector of the economy to the banks. Likewise, any accumulated current account deficit, Mca, is also reflected in domestic debt outside of, but funded by, the productive economy. Debt "bubbles" and credit "squeezes" occur when the banking system lends too much or too little debt into circulation. "Bubble" debt can be represented by an amount Mb (which can be positive or negative). The total, Mi, of this debt (Mi = Ms + Mca + Mb) represents the investment sector that trades in existing capital goods and financial assets.

In addition to the investment sector debt there is the dynamic transaction account debt, Mp, used to fund the productive economy. In New Zealand, that is presently estimated to be about 5.5% of the total debt. The total debt is called Domestic Credit (DC). It equals the productive debt, Mp, plus the investment sector debt, Mi, so that DC = Mp + Ms + Mca + Mb.

The equation DC = Mp + Ms + Mca + Mb is a modified form of the well known Fisher Equation of Exchange (M*V = P*Q) except that it takes the effects of interest-bearing debt into account. M in the Fisher equation is the money supply, V the number of times that money circulates in a given time period, P the price level and Q the economic output. P*Q is usually referred to as the gross domestic product or GDP. Since in the productive sector Mp = Pp*Qp/Vp, and in the investment sector Mi = Pi*Qi/Vi, the equation DC = Mp + Ms + Mca + Mb can be rewritten as DC = Pp*Qp/Vp + Pi*Qi/Vi. Both these equations offer profound insights into the way the existing debt system works.

EXPONENTIAL DEBT GROWTH

Debt growth in the investment sector is exponential because any interest rate creates an exponential curve when the interest is continually added to the existing debt. Debt growth in the productive sector must also be exponential because the productive sector has to fund the investment sector debt, Mi. The growth rate of the total debt, DC, will change over time according to the interest rate and physical changes in the debt base like those arising from the balance of trade, population growth and productivity. Debt has been growing much faster than nominal GDP in New Zealand in recent decades largely because of persistent current account deficits. Other countries have also generated "bubble" debt through excessive bank lending for speculation in assets like sub-prime mortgages and derivatives. In New Zealand, a moderate debt bubble developed prior to the sub-prime crisis towards the end of 2008.

INFLATION

The total debt (DC) must be funded from the productive economy because the investment sector doesn't produce any goods or services. The after-tax interest paid on bank deposits therefore causes systemic inflation in the productive economy. Subject to several qualifications, systemic inflation is about half the average interest rate on deposits. That means that increasing interest rates to manage inflation, as has been done around the world in recent decades, makes inflation worse, not better. High interest rates "work" only because they lead to heavy discounting as producers try to sell their stock to consumers whose purchasing power has been reduced due to more of their disposable income being transferred to deposit holders. The inevitable result of the process is rising unemployment, business failure and recession.

ASSET PRICES

The prices of existing capital assets tend to rise whenever the pool of investment sector deposits, Mi, increases faster than the net value of new capital assets being added to the investment pool. The relationship is given by the Fisher Equation of exchange Mi*Vi = Pi*Qi where Mi is the money in the investment pool, Vi is the speed of circulation of that money, Pi is the asset price level and Qi is the quantity of assets exchanged. Asset prices can also be affected when investors "sit on the sidelines" by leaving their deposits "in the bank". The speed of circulation, Vi, falls, which means either asset prices will fall or there will be less trading so that Qi falls, or both.

The increase in domestic debt, DC, is net of debt repayment, so when some non-bank investors deleverage, or "take losses" to repay their debt, Mi will be lower than it otherwise would have been and asset prices will tend to remain static or sometimes fall. In New Zealand and elsewhere this effect is accentuated when private banks become less willing to lend to their customers or to one another.

GROWTH

Economic growth arises mainly by monetising unpaid work, improving productivity and making better use of available human and natural resources. Emerging countries like BRICS (Brazil, Russia, India, China, South Africa) can often have much faster growth rates than mature economies because their own cash-based rural subsistence economies are being monetised and their domestic debt levels are increasing from a low base. It is relatively difficult to increase productivity in mature developed economies because they are predominantly service-based. In the United States of America about 76% of GDP is services, 22% industry and just 2% agriculture, and nearly all economic "growth" there in recent years has come from "financial" services, by waging war, and by further privatisation of health care.

In the debt system, if the speed of circulation, Vp, and prices, Pp, in the Fisher Equation (Mp*Vp = Pp*Qp) are constant in the productive economy, the money supply, Mp, must increase for GDP growth (Pp*Qp) to take place.

THE DEBT PROBLEM

The debt problem is that the total debt (DC) in many developed economies has become too high for the productive sector to service. That is the direct result of exponential debt growth in the interest-bearing debt-based financial system. When the total debt is growing much faster than the productive economy, more and more disposable income is being transferred as unearned income to deposit holders. Even when the total debt is growing at just 7% per year, the investment sector is doubling every 10 years. That means asset prices like houses rapidly become unaffordable while, in aggregate, most earned incomes remain static or fall in real terms. The direct result has been a hollowing-out of the income structure and rising inequality and poverty. The debt problem is especially dire in debtor countries like Greece and New Zealand that are carrying very high accumulated current account deficits (Mca) and in countries like the US where, due to poor regulatory oversight and irresponsible "sub-prime" lending, a massive bubble debt (Mb) was introduced into its financial system.

It is physically impossible to solve the debt problem while, as total debt grows exponentially, deposit holders are being paid more and more money for producing nothing. There is little risk to deposit holders in the modern banking system because many countries have some form of deposit insurance and in most places banks are bailed out by the public whenever they are considered "too big to fail". Using the price of money in the form of interest rates to manage the quantity of new debt issued is suicidal for the world economy. Since deposit interest causes systemic inflation, the debt system mechanics are creating a vicious circle. Depositors demand interest to protect against the inflation that the deposit interest payments create.

THE SOLUTION

The solution to the world's exponential debt problem is to remove unearned deposit interest income from the financial system. To do this, the quantity of money must be controlled directly for the public good instead of using deposit interest to do so, because deposit interest is destroying the world economy. The removal of deposit interest and the carefully managed supply of new money will reduce systemic inflation in both the productive and investment sectors towards zero.

The removal of deposit interest means that the ownership and issue of money must become the responsibility of a public agency acting in the national interest as has been the case throughout most of recorded history. Otherwise, once price control on the issue of new money, using interest rates, is removed, there would be little restraint on the quantity of new money issued as debt for profit by the banking system, leading to bubble formation and rapid inflation.

The banks could act as agents for the issue of new interest-free public debt money for the purchase of new capital assets, charging an administrative fee only and working within strict regulatory frameworks and lending criteria. The agency would take an ownership share in the new assets assessed to cover variable risk factors, with the agency share declining as the debt is repaid. Existing bank loans would remain the responsibility of the banks until the loan principal has been fully repaid. The interest rate charged on those existing bank loans would be reduced by their funding rate, and, other than supplementary charges they already have in place, the banks will not be able to charge fees or costs in excess of their bank spread.

The agency would, acting through the government, spend the small amount of new money needed for new production directly into the productive economy interest-free and debt-free. The supply of this new debt-free money will be used to keep inflation within a narrow band. If inflation rises beyond an established target figure, say 0.5%, the surplus money would be taxed out of the banking system; and if inflation is too low or turns negative, the agency would inject more new money into the productive economy.

The banks would manage new deposits and provide normal banking services for those new deposits for a service fee only. There will be no interest paid on deposits and no on-lending of deposits, thereby avoiding any possibility of debt increasing due to the multiple recycling of term deposits. Bank profits would not be affected by the change to the financial system because the service fees banks charge would still be comparable to their existing bank spread; enough to cover their costs and generate net income. The difference is that the quantity of money would be directly related to the production of goods and services instead of also funding unearned income and inflation.

There would be provision in the enabling legislation for registered and regulated investment institutions such as consumer finance houses, managed funds and pension funds. Consumer finance houses would engage only in specified consumption related activities. Credit card companies would be covered under the same rules as consumer finance houses. Managed funds and pension funds would be limited to specified investment activities and would not be able to invest in derivatives. Mortgage repayment schedules would, at the request of the borrowers, be adjusted to reflect the reduced interest rates.

The removal of interest on deposits may require the introduction of temporary measures to ensure any increase in purchasing power created by the removal of deposit interest does not cause "demand-pull" inflation in the productive economy. In New Zealand, removal of deposit interest could add about $10 billion to purchasing power on an annual basis. Some of that will be used for debt repayment, but a temporary savings scheme such as a government-supported fund for new productive investment, might be useful on a "shares for investment" basis. Suitable compensation for those, particularly the elderly, who are dependent on interest income for their standard of living, might also be considered. With inflation removed, the net annual effect of zero deposit interest in New Zealand would be quite small, in the order of 1% of the deposit.

MANAGING THE CURRENT ACCOUNT AND EXCHANGE RATE

The banks' foreign debt can only be repaid over time by selling more New Zealand assets to foreigners, or by reversing the current account deficit so it becomes positive. Reversing the current account deficit is the better choice, otherwise the resulting increase in domestic deposits from the further sale of New Zealand assets to foreigners would add to inflation in the investment sector.

The government, in association with the monetary agency and the Reserve Bank, will introduce a Foreign Transactions Surcharge (FTS) on all transfers of New Zealand deposits offshore including speculative short term trading in currency and commercial paper of all kinds. The FTS will be set at a level to bring the current account into sufficient surplus so that repayment of the accumulated current account deficit can begin. The FTS will be tax-neutral in that the money it raises will be used to reduce indirect domestic taxation like GST. There will need to be strict regulatory oversight to prevent the banks from trying to avoid FTS by "netting out" offshore transactions. The FTS does not involve new tax because it is fiscally neutral. Nor is it a tariff barrier. All it does is to provide a new tool that allows the orthodox foreign exchange rate mechanism to work properly. In theory, the exchange rate mechanism is supposed to correct the exchange rate to ensure the current account remains balanced, but speculative capital flows appear to prevent that from happening at the moment. The FTS ensures that people buying goods and services and remitting domestic currency offshore pay the true cost of doing so.

Abolishing deposit interest and removing the banks’ funding rate from the interest paid on existing loans would mean the banks no longer receive enough interest income to cover their offshore debt-servicing costs. Until the banks' foreign debt has been repaid, the monetary agency will create new interest-free and debt-free money to pay the banks' offshore funding costs. The banks will pledge corresponding domestic loan assets as collateral for their existing foreign debt. The collateral will be reduced as the foreign bank loans are repaid from net foreign income generated by the FTS. The exchange settlement process means that the foreign interest payments funded by the agency will return to the banks as domestic deposits and increase foreign ownership of the country's economy. It is therefore in the national interest to repay the foreign bank debt as quickly as possible, and the desired rate of repayment will determine the level of the FTS. The money creation to pay for the foreign funding cost is a form of debt monetisation and it should lower the New Zealand dollar exchange rate against the country's trade weighted index. This should feed back into a reduction of the FTS.

[Comment: In New Zealand, 2011, based on net foreign exchange assets of -NZ$70 billion and with the Official Cash Rate at 2.5%, the agency injection would be up to NZ$2.5 billion per year, which would add roughly 1%/year to asset inflation in the first year, reducing progressively to zero as the debt is repaid.]